Banking in the conventional sense (as opposed to Islamic Banking) and the banking system as most of the world knows it, was built around the concept of credit. Banks provided credit to customers and in return received compensation typically in the form of interest payments. For this reason the conventional banking system has been referred to as an “interest-based system”. However one of the drawbacks with an interest-based system is that interest rates aren’t always going to be set fairly and because of this, segments of society might not have access to credit markets or, worse, could become victims to predatory lending. This very problem is one of the key ideas that led to the formation of Islamic Banking in the mid-1970s.
What is Islamic Banking and Islamic Finance)?
To understand Islamic Banking and Islamic Finance, we first have to discuss Shari’ah (also spelt Sharia and Shari’a) which is a body of religious law based on the teachings of the Quran, the Sunna and other sources such as Ijma and Qiyas. It’s literal meaning is “the way”. Islamic Banking and Finance are derived from the principles that are embedded in Shari’ah code. A fundamental underpinning of Islamic Banking is the idea of risk-sharing between borrower and lender. Research from the International Monetary Fund summarized the principles governing Islamic Finance into three areas:
- The Principle of Equity – this is based on a belief that transacting parties should transact in an equitable manner. This is where the concept of riba comes in. Riba means an increase in wealth that isn’t related to productive activities, which goes against the principle of equity as it is wealth that is created without doing anything. Transacting parties should also limit “excessive uncertainty” from contracts and avoid information asymmetry. By adopting these beliefs the playing field between two transacting parties is leveled, and more equitable.
- The Principle of Participation – this principle is a function of the prohibition of Riba, that is, there needs to be a relationship between risk and reward. A reward should be earn in relation to the risk that is taken. This principle is important in how many products in Islamic Banking are designed.
- The Principle of Ownership – this principle is about not selling what you don’t own. This would include activities like short selling and margin trading in the securities market. This principle also advocates possession of assets.
So unlike the conventional banking system which is centered on the setting and charging of interest rates, in Islamic Banking interest-based transactions are strictly prohibited. Philosophically the approach is focused on increased visibility among the transacting parties, aligning risk and reward and sharing of profits and losses.
Emirates Islamic Bank summarized the principles of Islamic Banking into 5 rules:
- Any predetermined payment over and above the loan principal is prohibited.
- The Bank must share in profits or losses arising out of the enterprise for which money was financed (lent).
- Making money from money is not acceptable. (this is a version of productive activities which was discussed above).
- Uncertainty, risk or speculation is prohibited.
- Investments should only support practices or products that are not forbidden.
Today there is over $3 trillion of banking assets that are managed and governed by Islamic Banking principles. The below chart, courtesy of research from Refinitiv in December 2020, shows the history of Islamic Banking assets from 2012 through 2019.
Adoption has clearly grown over the past decade and the industry represents a not insignificant percentage of equivalent global financial assets.
Islamic Banking Products
Islamic Banks offer their customers several financial products that are structured in a way that is compliant with Shari’ah principles. These products include (but are not limited to):
- Murabaha – with these products, the bank purchases a property or asset and re-sells it to a customer at a mark-up price and the customer repays the bank in installments over an agreed period of time. This is a very different arrangement from a conventional mortgage arrangement between a borrower and bank/lender.
- Ijarah – this is a lease that is entered into between a bank and a customer. The customer agrees to pay rent over a specified period of time and the bank promises to transfer ownership to the customer at the end of the time period, assuming all payments have been made. The leasing period is usually 3-7 years.
- Musharaka – the meaning of this word is “sharing”. Musharaka products are a partnership between the customer and the bank where the bank provides financing for the customer’s projects and shares capital, risk and returns.
- Sukuk – these are the Islamic Banking equivalent of a bond. The return on a given Sukuk is the result of the yield that the investment generates. These instruments, like all others discussed above, are structured in a Shari’ah compliant manner.
Overview of Islamic Banks
Describing a bank as an Islamic Bank is a little complicated because some banks will only provide Shari’ah compliant products while others offer both Shari’ah compliant and conventional products. So drawing a hard line is a complex matter. The below list however includes the banks that have the most significant Islamic Banking assets:
- Al Rajhi Bank
- Dubai Islamic Bank
- Kuwait Finance House
- Qatar Islamic Bank
- Masraf Al Rayan
- Abu Dhabi Islamic Bank
- Bank Albilad
- Albaraka Banking
- Bank Al-Jazira
- Boubyan Bank
- Bank Islam Malaysia
- Bank Syariah Indonesia
- Islami Bank Bangladesh
- Emirates Islamic Bank
- Qatar International Islamic
- Sharjah Islamic Bank
- Warba Bank